Why Backdate Stock Options?

Here's a discussion of the option backdating controversy from James Surowiecki at The New Yorker:

The Dating Game, by James Surowiechi, The New Yorker: ..When news broke, earlier this year, that some companies had backdated stock-option grants ... in order to make them more valuable, it seemed like a problem that would come and go quickly... But the scandal has metastasized... What’s distinctive about this one is that the benefits companies got from backdating were so small. Never, you might say, have so many cheated so much to gain so little.

The most common stock options are known as “at the money” options, which let you buy the company’s stock at the price that it had on the day of the grant. They’re valuable only if the stock price rises after you get them. The companies involved in the recent scandal were backdating options to a time when the stock price was lower, making them immediately lucrative. As it happens, companies are perfectly free to issue options priced below the current market: those are called “in the money” options, and they’re worth something right when they’re issued. .. But there’s a rule that companies have to follow when they issue “in the money” options: they have to disclose it in their financial statements.

The backdating companies broke this rule: they reported how many options they were issuing, but conveniently omitted the fact that they had been backdated. In Washington, people say that it’s not the crime that gets you—it’s the coverup. In the case of backdating, the only crime was the coverup.

The question is why anyone bothered. ... [C]ompanies didn’t need backdating to lavish huge sums of money on their executives: they could have issued more at-the-money options to make up the difference, or they could have just handed out grants of stock. ... Why did they sneak around? One reason is public relations. Companies typically justify ... stock options by claiming that they’re an incentive for performance: the executives get rich only if they do a good job and the stock goes up. Unless executives can time-travel, though, it’s hard to make that case for backdated options.

The bigger reason for choosing to backdate is to get around some bothersome accounting regulations. Until recently, the regulations distinguished, for no good reason, between in-the-money and at-the-money options. In-the-money options—but not at-the-money options—had to be recorded as an expense, which drove down reported earnings. Backdating allowed companies to reward employees with in-the-money options while getting the favorable accounting treatment of at-the-money options. ...

Classifying the options properly would have lowered the number in the “earnings” box, and so C.E.O.s assumed that it would also drag down the company’s stock price. They played games with their accounting because they thought investors weren’t smart enough to look at the fundamentals. They were “managing earnings,” massaging the numbers, something that many (perhaps most) companies do in some form or other... Executives do it because they believe that if they don’t the stock market will punish them.

They’re wrong. As the investment strategist Michael Mauboussin puts it, “The market follows cash flows,” not earnings. As long as revenues and expenditures are reported honestly, [several studies show that] accounting legerdemain doesn’t fool the market. ...